1

CHAPTER TWO PROBLEMS 1. Your corporation has the following cash flows: Operating income $250,000 Interest received 10,000 Interest paid 5,000 !ividends received 20,000 !ividends paid 50,000 If the applica"le ta# ta"le is as follows: $a#a"le Income %ate &&&&&&&&&&&&&& &&&& $ 0 & 25,000 1'( 25 & 50,000 1) 50 & *5,000 +0 *5 &100,000 0 over 100,000 ' ,hat is the corporation-s ta# lia"ilit./ $00,5+0 2. 1ast .ear %attner %o"otics had $5 million in operating income 234I$5. $he compan. had net depreciation e#pense of $1 million and an interest e#pense of $1 million6 its corporate ta# rate was 0 percent. $he compan. has $1 million in current assets and $ million in non&interest&"earing current lia"ilities6 it has $15 million in net plant and e7uipment. It estimates that it has an after&ta# cost of capital of 10 percent. 8ssume that %attner9s onl. non&cash item is depreciation. a. ". c. d. e. ,hat was the compan.9s net income for the .ear/ $2. million ,hat was the compan.9s net cash flow/ $+. million ,hat was the compan.9s net operating profit after ta#es 2:O;8$5/ $+.0 million ,hat was the compan.9s operating cash flow/ $ .0 million If operating capital in the previous .ear was $2 million, what was the compan.9s free cash flow 2<=<5 for the .ear/ $2.0 million ,hat was the compan.9s economic value added/ $500,000

f.

+.

8s an institutional investor pa.ing a marginal ta# rate of '(, .our after&ta# dividend

.ield on preferred stoc> with a 1'( "efore&ta# dividend .ield would "e: 1 .)( . 8 *( coupon "ond issued ". the state of :ew Yor> sells for $1,000 and thus provides a *( .ield to maturit.. <or an investor in the 0( ta# "rac>et, what coupon rate on a =arter =hemical =ompan. "ond that also sells at its $1,000 par value would cause the two "onds to provide the investor with the same after&ta# rate of return/ 11.'*( 5. 8 corporation with a marginal ta# rate of '( would receive what 8<$3%&$8? YI31! on a 12( coupon rate preferred stoc> "ought at par/ 8nswer: 11.1*2( '. You have @ust received financial information for the past two .ears for ;owell ;anther =orporation: Income Atatements 3nding !ecem"er +1 2millions of dollars5 2000 Aales $1,200.0 Operating =osts 2e#cluding depreciation5 1,020.0 !epreciation +0.0 3arnings "efore interest and ta#es $ 150.0 1ess Interest e#pense 21.* 3arnings "efore ta#es $ 120.+ 1ess ta#es 2 0(5 51.+ :et income availa"le to common e7uit. $ **.0 =ommon dividends $ 0.'05 4alance Aheets 3nding !ecem"er +1 2millions of dollars5 2000 =ash and mar>eta"le securities $ 12.0 8ccounts receiva"le 100.0 Inventories 100.0 :et plant and e7uipment +00.0 $otal 8ssets $ '*2.0 8ccounts pa.a"le :otes pa.a"le 8ccruals 1ong&term "onds =ommon stoc> 250 million shares5 %etained earnings $otal lia"ilities and e7uit. a. $ 100.0 '*.0 *2.0 $ 150.0 50.0 225.0 $ '*2.0

1))) $1,000.0 050.0 25.0 $ 125.0 20.2 $ 10 .0 1.) $ '2.) $ 0. '

1))) 10.0 150.0 200.0 250.0 $ '10.0 $ $ )0.0 51.5 '0.0 $ 150.0 50.0 200.5 $ '10.0

,hat is the net operating profit 2:O;8$5 for 2000/

$)0,000,000 ". ,hat are the amounts of net operating wor>ing capital for 1))) and 2000/ $210,000,000 and $1)2,000,000 c. ,hat are the amounts of total operating capital for 1))) and 2000/ $ '0,000,000 and $ )2,000,000 d. ,hat is free cash flow for 2000/ $50,000,000 e. Bow much did the firm reinvest in itself over the accounting period/ $1',500,000 f. 8t the present time 212C+1C20005, how large a chec> could the firm write without it "ouncing/ $12,000,000 *. 8 firm-s operating income 234I$5 was $ 00 million, their depreciation e#pense was $ 0 million, and their increase in net investment in operating capital was $*0 million. 8ssuming that the firm is in the 0( ta# "rac>et, what was their free cash flow/ $1*0 million 0. In its recent income statement, Amith Aoftware Inc. reported $2+ million of net income, and in its .ear&end "alance sheet, Amith reported $ 01 million of retained earnings. $he previous .ear, its "alance sheet showed $+0) million of retained earnings. ,hat were the total dividends paid to shareholders during the most recent .ear/ $11.0 million ). =o# =orporation recentl. reported an 34I$!8 of $50 million and $* million of net income. $he compan. has $12 million interest e#pense and the corporate ta# rate is 0.0( percent. ,hat was the compan.-s depreciation and amortiDation e#pense/ $+ .++ million 10. %avings Incorporated recentl. reported net income of $5. million. Its operating income 234I$5 was $15 million, and its ta# rate was 0 percent. ,hat was the compan.9s interest e#pense/ $' million 11. In its recent income statement, Amith Aoftware Inc. reported pa.ing $10 million in dividends to common shareholders, and in its .ear&end "alance sheet, Amith reported $ 1) million of retained earnings. $he previous .ear, its "alance sheet showed $ 0

million of retained earnings. ,hat was the firm9s net income during the most recent .ear/ $25.0 million 12. =ase. Eotors recentl. reported net income of $1) million. $he firm-s ta# rate was 0.0( and interest e#pense was $' million. $he compan.-s after&ta# cost of capital is 1 .0( and the firm-s total investor supplied operating capital emplo.ed e7uals $)5 million. ,hat is the compan.-s 3F8/ $).+0 million 1+. 4roo>s Aisters- operating income 234I$5 is $1) million. $he compan.-s ta# rate is 0.0(, and its operating cash flow is $1 0. million. $he compan.-s interest e#pense is $+) million. ,hat is the compan.-s net cash flow/ 28ssume that depreciation is the onl. non&cash item in the firm-s financial statements.5 $125.0 million 1 . Falua"le Incorporated9s stoc> currentl. sells for $ 5 per share. $he firm has 20 million share of common outstanding. $he firm9s total de"t e7uals $'00 million and its common e7uit. e7uals $ 00 million. ,hat is the firm9s mar>et value added/ $500 million CHAPTER THREE PROBLEMS 1. 84=, Inc., sells all its merchandise on credit. It has a profit margin of (, an average collection period of '0 da.s, receiva"les of $150,000, total assets of $+ million and a de"t ratio of 0.' . ,hat is the firm-s return on e7uit./ +.++ percent 2. $he Am.the =orporation-s common stoc> is currentl. selling at $100 per share which represents a ;C3 ratio of 10. If the firm has 100 shares of common stoc> outstanding, a return on e7uit. of 0.20, and a de"t ratio of 0.'*, what is its return on total assets/ '.* percent +. If ,in>ler, Inc., has sales of $2 million per .ear 2all credit5 and an average collection period of +5 da.s, what is its average amount of accounts receiva"le outstanding 2assume a +'0 da. .ear5/ $1) , . If a firm has total interest charges of $10,000 per .ear, sales of $1 million, a ta# rate of 0(, and a net profit margin of '(, what is the firm-s times interest earned ratio/ 11 times 8 firm that has an e7uit. multiplier of .0 will have a de"t ratio of: 0.*5.

5.

'.

Given the following information, calculate the mar>et price per share of ,8E, Inc.: 3arnings after interest and ta#es 3arnings per share Atoc>holders- e7uit. Ear>etC4oo> ratio $ .00 H H H H $200,000 $2.00 $2,000,000 0.20

*.

8 fire has destro.ed a large percentage of the financial records of Banson 8ssociates. You are charged with piecing together information in order to release a financial report. You have found the return on e7uit. to "e 10(. If sales were $ million, the de"t ratio 0. 0, and total lia"ilities $2 million, what was the return on assets/ 10.0(

0.

8ssume =onservative =orporation is 100( e7uit. financed. =alculate the return on e7uit. given the following information: 1. 2. +. . 5. 3arnings "efore ta#es H $2,000 Aales H $5,000 !ividend pa.out ratio H '0( $otal asset turnover H 2.0 8pplica"le ta# rate H 50( 0 percent

).

You are considering a new product for .our firm to sell. It should cause a 15( increase in .our profit margin "ut it will also re7uire a 50( increase in total assets. You e#pect to finance this asset growth entirel. ". de"t. If the following ratios were computed "efore the change, what will "e the new %O3 if the new product is sold "ut sales remain constant/ ;rofit margin H 0.10 $otal asset turnover H 2.0 37uit. multiplier H2 ' percent

10.

Iohnstown =hemicals, Inc., has a current ratio of +.0, a 7uic> ratio of 2. , and an inventor. turnover of '. Iohnstown-s total assets are $1 million and its de"t ratio is 0.20. 2$he firm has no long&term de"t.5 ,hat is Iohnstown-s sales figure/ $*20,000

11.

=alculate the mar>et price of a share of 84=, Inc., given the following information: Atoc>holders- e7uit. H $1,2506 priceCearnings ratio H 56 shares outstanding H 256 mar>etC"oo> ratio H 1.5. $*5.00

12.

Iamestown, Inc., has earnings after interest deductions "ut "efore ta#es of $+00. $he compan.-s "efore&ta# times interest earned ratio is *.00. =alculate the compan.-s interest charges. $50.00 $he G. Bo""s =ompan. has determined that its return on e7uit. is 15(. Eanagement is interested in the various components that went into this calculation. Bowever, one of the accountants has misplaced the profit margin ratio. 8s a finance wiDard, .ou >now how to calculate the profit margin, given the following information: total de"tCtotal assets H 0.+5, and total asset turnover H 2.0. ,hat is the profit margin/ +. 0 percent

1+.

1 .

1owe J =ompan. has a de"t ratio of 0.5, a capital intensit. ratio of , and a profit margin of 10(. $he 4oard of !irectors is unhapp. with the current return on e7uit. 2%O35, and the. thin> it could "e dou"led. $his could "e accomplished 215 ". increasing the profit margin to 12( and 225 ". increasing de"t utiliDation. $otal asset turnover will not change. ,hat new de"t ratio, along with the 12( profit margin, is re7uired to dou"le the %O3/ *0 percent $he 1ocal =ompan. is a relativel. small, privatel. owned firm. In 1)01 1ocal had an after&ta# income of $15,000, and 10,000 shares were outstanding. $he owners were tr.ing to determine the e7uili"rium mar>et value for 1ocal-s stoc>, prior to ta>ing the compan. pu"lic. 8 similar firm that is pu"licl. traded had a priceCearnings ratio of 5.0. Ksing onl. the information given, estimate the mar>et value of one share of 1ocal-s stoc>. $*.50

15.

1'.

3psilon =o.-s records have recentl. "een destro.ed ". fire. Given the following "its of information saved from the inferno, determine 3psilon-s net income for 1))). %eturn on e7uit. 22( 8ssetsCnet worth 2.1'* ;rofit margin 5.'( $otal assets $'50 million $ ''.00 million

1*.

!elta =orp. has sales of $+00,000, a profit margin of '.5 percent, a ta# rate of 15 percent, and annual interest charges of $*,500. ,hat is !elta-s times interest earned/ .0'

10.

=oastal ;ac>aging Ls %O3 last .ear was onl. + percent, "ut its management has developed a new operating plan designed to improve things. $he new plan calls for a total de"t ratio of '0 percent, which will result in interest charges of $+00 per .ear. Eanagement pro@ects an 34I$ of $1,000 on sales of $10,000, and it e#pects to have a total asset turnover ratio of 2.0. Knder these conditions, the average ta# rate will "e +0 percent. If the changes are made, what return on e7uit. will =oastal earn/

2 .5 percent 1). Yohe Inc. has an %O8 of 1+. ( and a 10( profit margin. $he compan. has sales e7ual to $5 million. ,hat are the compan.-s total assets/ $+.*+ million 20. Yohe Inc. has a current ratio of 2, and a 7uic> ratio of 1. . <urthermore, the firm has $1.5 million in current lia"ilities. 4ased upon this information, how much inventor. is Yohe holding/ $)00,000 21. K M:O, Inc. uses onl. de"t and common e7uit. funds to finance its assets. $his past .ear the firm-s return on total assets was 1+(. $he firm financed 2( percent of its assets using de"t. ,hat was the firm-s return on common e7uit./ 22. 1( 22. =leveland =orporation has 1*, )0,000 shares of common stoc> outstanding, its net income is $1) million, and its ;C3 ratio is 15.1. ,hat is the compan.9s stoc> price/ $1'*. ) 2+. 888-s inventor. turnover ratio is 11.0) "ased on sales of $15,200,000. $he firm-s current ratio e7uals +.22 with current lia"ilities e7ual to $)*0,000. ,hat is the firm-s 7uic> ratio/ 1.01

CHAPTER FOUR PROBLEMS 1. Interest rates on one&.ear $reasur. securities are currentl. 5.' percent, while two&.ear $reasur. securities are .ielding ' percent. If the pure e#pectations theor. is correct, what does the mar>et "elieve will "e the .ield on one&.ear securities one .ear from

now/ '. percent 2. Interest rates on four&.ear $reasur. securities are currentl. * percent, while interest rates on si#&.ear $reasur. securities are currentl. *.5 percent. If the pure e#pectations theor. is correct, what does the mar>et "elieve that two&.ear securities will "e .ielding four .ears from now/ 0.5 percent +. $he real ris>&free rate of interest is + percent. Inflation is e#pected to "e 2 percent this .ear and percent during the ne#t two .ears. 8ssume that the maturit. ris> premium is Dero. ,hat is the .ield on +&.ear $reasur. securities/ '.++ percent . 8 $reasur. "ond that matures in 10 .ears has a .ield of ' percent. 8 10&.ear corporate "ond has a .ield of 0 percent. 8ssume that the li7uidit. premium on the corporate "ond is 0.5 percent. ,hat is the default ris> premium on the corporate "ond/ 1.5 percent 5. One&.ear $reasur. securities .ield 5 percent. $he mar>et anticipates that 1 .ear from now, one&.ear $reasur. securities will .ield ' percent. If the pure e#pectations theor. is correct, what should "e the .ield toda. for 2&.ear $reasur. securities/ 5.5 percent '. $he real ris>&free rate is + percent, and inflation is e#pected to "e + percent for the ne#t 2 .ears. 8 2&.ear $reasur. securit. .ields '.2 percent. ,hat is the maturit. ris> premium for the 2&.ear securit./ 0.2 percent *. $he real ris>&free rate is + percent. Inflation is e#pected to "e + percent this .ear, percent ne#t .ear, and then +.5 percent thereafter. $he maturit. ris> premium is estimated to "e 0.0005 ? 2t&15, where t H num"er of .ears to maturit., ,hat is the nominal interest rate on a *&.ear $reasur. note/ '.0 percent

0.

8ssume that the real ris>&free rate is 2 percent and that the maturit. ris> premium is Dero. If the nominal rate of interest on 1&.ear "onds is 5 percent and that on compara"le ris> 2&.ear "onds is * percent, what is the 1&.ear interest rate that is e#pected for .ear two/ * percent

).

You see that the current +0&da. $&"ill rate is .5(. You are told ". a friend who wor>s for an investment firm that the "est estimates of the current interest rate premiums for relativel. safe corporate firms is as follows: inflation premium H 2.1(6 default ris> premium H 1. (. 4ased on this data, what is the real ris>&free rate of return/ 2. (

10.

$he real ris>&free rate of interest is + percent. Inflation is e#pected to "e 5 percent this coming .ear, @ump to ' percent ne#t .ear, and increase to * percent the following .ear 2Year +5. 8ccording to the e#pectations theor., what should "e the interest rate on +& .ear, ris>&free securities toda./ ) percent

11.

!rongo =orporation9s &.ear "onds currentl. .ield 0. percent. $he real ris>&free rate of interest, >N, is 2.* percent and is assumed to "e constant. $he maturit. ris> premium 2E%;5 is estimated to "e 0.1(2t & 15, where t is e7ual to the time to maturit.. $he default ris> and li7uidit. premiums for this compan.9s "onds total 0.) percent and are "elieved to "e the same for all "onds issued ". this compan.. If the average inflation rate is e#pected to "e 5 percent for .ears 5, ', and *, what is the .ield on a *&.ear "ond for !rongo =orporation/ 0.)1 percent

12.

One&.ear $reasur. securities .ield ' percent, 2&.ear $reasur. securities .ield '.5 percent, and +&.ear $reasur. securities .ield * percent. 8ssume that the e#pectations theor. holds. ,hat does the mar>et e#pect will "e the .ield on 1&.ear $reasur. securities two .ears from now/ 0 percent

1+.

8ssume that a +&.ear $reasur. note has no maturit. ris> premium, and that the real ris>&free rate of interest is + percent. If the $&note carries a .ield to maturit. of 10 percent, and if the e#pected average inflation rate over the ne#t 2 .ears is 0 percent, what is the implied e#pected inflation rate during Year +/ 5 percent

CHAPTER FIVE PROBLEMS 1. 8n investor holds a diversified portfolio consisting of a $5,000 investment in each of 20 different common stoc>s. $he portfolio "eta is e7ual to 1.12. $he investor has decided to sell a lead mining stoc> 2"eta H 1.05 at $5,000 net and use the proceeds to "u. a li>e amount of a steel compan. stoc> 2"eta H 2.05. ,hat is the new "eta for the portfolio/

10

1.1* 2. =onsider the following information and calculate the re7uired rate of return for the ,in>ler Investment <und. $he total investment fund is $2 million. Atoc> &&&&& 8 4 = ! Investment &&&&&&&&&& $ 200,000 +00,000 500,000 1,000,000 4eta &&&& 1.50 &0.50 1.25 0.*5

$he mar>et re7uired rate of return is 15( and the ris>&free rate is * percent. 1+.1 percent +. $he Aand. =ompan. has developed the following data regarding a pro@ect to add new distri"ution facilities: A$8$3 ;%O484I1I$Y ;%OI3=$ %3$K%: E8%M3$ %3$K%: 1 .+ 0.01 0.10 2 .* 0.15 0.1 8. 4. =. !. 3. ,hat is the e#pected return on the pro@ect/ ,hat is the standard deviation of the pro@ect returns/ ,hat is the coefficient of variation of pro@ect returns/ ,hat is the covariance of pro@ect returns with mar>et returns/ 10.0( 0.0' 2 0.5) 0.0012

,hat is the correlation coefficient "etween the pro@ect returns and the mar>et returns/ 1.00

=alculate the re7uired rate of return for Eanagement, Inc., assuming that investors e#pect a 5( rate of inflation in the future. $he real rate is e7ual to +( and the mar>et ris> premium is 5(. Eanagement has a "eta of 2.0 and has historicall. returned an average of 15(. 10 percent <irst Investment $rust is a mutual fund investing in the common stoc> of si# firms. $he firms, mar>et value of shares held, and the "eta of each stoc> are as follows: E8%M3$ F81K3 O< <I%E AB8%3A B31! 43$8 8ce 3lectronics $ )0 million 0.' 4o"-s Industries 110 million 1.2 =4E International '0 million 0.* !ave-s =en 1+0 million 1.0 3d-s 3ater. *0 million 0.) Apace !eli 0 million 2.5 $otal 500 million

5.

11

8. 4. '.

=alculate the "eta of the mutual fund.

1.25

Auppose %m H 1' percent and %f H ' percent6 what is the e#pected portfolio return/ 10.5 percent

$he following data pertains to the ne#t four 7uestions. Atoc>s 8 and 4 have returns and pro"a"ilit. distri"utions as given "elow. ;%O484I1I$Y 0.25 0.+0 0.25 0.20 8. 4. =. !. 3. A$O=M 8 '( 10( ( 0( A$O=M 4 0( 2( '( 0(

=alculate the e#pected returns for Atoc>s 8 and 4. *.1( and 5.*( ,hat are the standard deviations of e#pected returns for Atoc>s 8 and 4/ 2.+2( and 2.55( $he covariance "etween Atoc>s 8 and 4 is: &0.000+'* $he correlation coefficient "etween Atoc>s 8 and 4 is: &0.'2 Auppose .ou want to hold a portfolio composed of 50( of Atoc> 8 and 50( of Atoc> 4. ,hat will "e the e#pected return 2mean5 and ris> 2standard deviation5 of .our portfolio/ '. ( and 1.0*(

*.

You are managing a portfolio of 10 stoc>s which are held in e7ual amounts. $he current "eta of the portfolio is 1.' , and the "eta of Atoc> 8 is 2.0. If Atoc> 8 is sold, what does the "eta of the replacement stoc> have to "e to have a new portfolio "eta of 1.55/ 1.10

0.

Given the following information concerning 8AA3$A ? and Y: ;ossi"le Outcomes 1 2 + 5 %eturns of ;ro"a"ilit. 0.10 0.20 0. 0 0.20 0.10 8ssets ? 0.00 0.00 0.12 0.+0 0.'0 Y &0.0 0.10 0.12 0.1 0.1'

12

8.

,hat are the e#pected returns for 8AA3$A ? and Y given the a"ove pro"a"ilities/ 10. 0 percent and10.00 percent

4.

,hat is the e#pected return of a portfolio comprised of 0 percent of an investor-s wealth invested in 8AA3$ ? and '0 percent invested in 8AA3$ Y/ 1+.0 percent ,hat are the standard deviations of the returns of the two securities/ 1'. percent and 5.2 percent

=.

!.

,hat is the =OF8%I8:=3 "etween the two securities/ 0.005 00

3.

,hat is the =O%%318$IO: "etween these two securities/ 0.'+'

<.

,hat is the standard deviation of a portfolio comprised of 0 percent of an investor-s wealth invested in 8AA3$ ? and '0 percent invested in 8AA3$ Y/ 0.)+ percent

CHAPTER SIX PROBLEMS 1. If .ou "u. a factor. for $250,000 and the terms are 20( down, the "alance to "e paid off over +0 .ears at a 12( rate of interest on the unpaid "alance, what are the +0 e7ual annual pa.ments/ $2 ,02) 2. 8n investor is considering the purchase of 20 acres of land. Bis anal.sis is that if the land is used for cattle graDing, it will produce a cash flow of $1,000 per .ear indefinitel.. If the investor re7uires a return of 10( on investments of this t.pe, what is the most he would "e willing to pa. for the land/

13

$10,000 +. You start saving for .our college education. You "egin college at age 10 and .ou will need $ ,000 per .ear at the end of each of the ne#t .ears. You will ma>e a deposit 1 .ear from toda. in an account which pa.s '( compounded annuall. and an identical deposit each .ear until .ou start college. If a deposit of $1,)0* will allow .ou to reach .our goal, how old are .ou now/ 12 .ears old 4. On Ianuar. 1, 1))5, a graduate student developed a financial plan which would provide enough mone. at the end of his graduate wor> 2Ianuar. 1, 20005 to open a "usiness of his own. Bis plan was to deposit $0,000 per .ear, starting immediatel., into an account pa.ing 10( compounded annuall.. Bis activities proceeded according to plan e#cept that at the end of his third .ear he withdrew $5,000 to ta>e a =ari""ean cruise, at the end of the fourth .ear he withdrew $5,000 to "u. a used =amaro, and at the end of the fifth .ear he had to withdraw $5,000 to pa. to have his dissertation t.ped. Bis account, at the end of the fifth .ear, will "e less than the amount he had originall. planned on ". how much/ $1',550 5. You have "een given the following cash flows. ,hat is the present value 2t H 05 if the discount rate is 12(/ 0 1 2 + 5 ' &&O&&&&&&&&&&O&&&&&&&&&&O&&&&&&&&&&O&&&&&&&&&&O&&&&&&&&&&O&&&&&&&&&&O&&&& $0 $1 $2000 $2000 $2000 $0 &$2000 $+,2*' '. 84= =orporation has "een en@o.ing a phenomenal rate of growth since its inception one .ear ago. =urrentl. assets total $100,000. If growth continues at the current rate of 12( compounded 7uarterl., what will "e total assets in 2 1C2 .ears/ $1+ ,+)0 *. =harter 8ir is considering the purchase of an aircraft to supplement its current fleet. In estimating the impact of adding this craft to their fleet, the. have developed the following cash flow anal.sis: 3nd of .ear 1 2 + 5 ' * &$1,000 $100,000 $100,000 $100,000 $100,000 $100,000 &$+00,000

If the discount rate is 10(, what is the present value of these estimated flows/

14

$10),*52 0. <ind the present value for the following income stream if the interest rate is 12 percent. Y38%A 1& 5&10 11&15 8. 4. =. !. 3. $5',**' $52,500 $ ,* 0 $ 0,'2* $'5,25* =8AB<1O, $ 5,000 $ *,500 $ 10,000 <. G. B. $ 5,+*) $ ',+)0 $5*,)11

$+1,1 0.50 ). You are thin>ing a"out "u.ing a car, and a local "an> is willing to lend .ou $20,000 to "u. the car. Knder the terms of the loan, it will "e full. amortiDed over five .ears 2'0 monthl. pa.ments5 and the nominal interest will "e 12 percent. ,hat would "e the monthl. pa.ment on the loan/ $ 10. .0)

You have "een saving mone. for the last two .ears. You made deposits of $100 on Ianuar. 1, 1)01, and Iul. 1, 1)01, in a savings account pa.ing 10( compounded semi&annuall.. On Ianuar. 1, 1)02, the "an> increased the interest rate paid on savings accounts to 12(, annual compounding. You made a third $100 deposit on 8pril 1, 1)02. Bow much will "e in .our account on Ianuar. 1, 1)0+/ $+ ).)5

11.

You plan on wor>ing for 10 .ears and then leaving for the 8las>an P"ac> countr.Q. You figure .ou can save $1,000 a .ear for the first 5 .ears and $2,000 a .ear for the last 5 .ears. In addition, .our famil. has given .ou a $5,000 graduation gift. If .ou put the gift and .our future savings in an account pa.ing 0 percent compounded annuall., what will .our Psta>eQ "e when .ou leave for the wilderness 10 .ears hence/ $+1,1 0 If $100 is placed in an account that earns a nominal (, compounded 7uarterl., for 5 .ears, what will it "e worth in 5 .ears/ $122.02

12.

1+.

Bess !istri"utors is financing a new truc> with a loan of $10,000 to "e repaid in 5 annual installments of $2,505. ,hat annual interest rate is the compan. pa.ing/ 0(

1 .

You have decided to deposit .our scholarship mone. 2$1,0005 in a savings account pa.ing 0( interest, compounded 7uarterl.. 3ighteen months later, .ou decide to go to the mountains rather than school and .ou close out .our account. Bow much mone.

15

will .ou receive/ $1,12' 15. $he present value 2t H 05 of the following cash flow stream is $',)*).0 when discounted at 1+( annuall.. ,hat is the value of the EIAAI:G 2t H 25 cash flow/ 0 1 2 + &&&O&&&&&&&&&&&&O&&&&&&&&&&O&&&&&&&&&&&O&&&&&&&&&&&O&&&&& $0 $ )00 $/ $2,100 $1,000 $ ,'2* 1*. You want to set up a trust fund. If .ou ma>e a pa.ment at the end of each .ear for twent. .ears and earn 10( per .ear, how large must .our annual pa.ments "e so that the trust is worth $100,000 at the end of the twentieth .ear/ $1,* 5.)' 10. $welve .ears ago .ou "ought a $25 stoc> which is now worth $*0. *. 8ssuming that the stoc> paid no dividends, the rate of return on .our investment was: 10( 1). Atarting on Ianuar. 1, 1))1, and then on each Ianuar. 1 until 2000 210 pa.ments5, .ou will ma>e pa.ments of $1,000 into an investment which .ields 10 percent. Bow much will .our investment "e worth on !ecem"er +1 in the .ear 2010/ $ 5, '0.2' 20. Your ')&.ear old aunt has savings of $+5,000. Ahe has made arrangements to enter a home for the aged on reaching the age of 00. Your aunt wants to decrease at a constant amount each .ear for ten .ears, with a Dero "alance remaining. Bow much can she withdraw each .ear if she earns ' percent annuall. on her savings/ Ber first withdrawal would "e one .ear from toda.. :. $ ,*55 21. 8 rich aunt promises .ou $+5,000 e#actl. 5 .ears after .ou graduate from college. ,hat is the value of the promised $+5,000 if .ou could negotiate pa.ment upon graduation/ 8ssume an interest rate of 12 percent. $1),0'0.05 22. In planning to "u. a home .ou are putting $2,500 of .our end of .ear "onus in an account that earns 10 percent. If .our first pa.ment "egins in e#actl. one .ear, how much of a down pa.ment will .ou "e a"le to afford at the end of .ears/ $11,'02.50 2+. <red Iohnson is retiring one .ear from toda.. Bow much should <red currentl. have in a retirement account earning 10 percent interest to guarantee withdrawals of $25,000 per .ear for 10 .ears/

16

$15+,'15 2 . If .ou were promised 10 annual pa.ments of $ ,000 starting with the first pa.ment toda., compute the present value of these flows if .our opportunit. cost is * percent. $+0,0'0.00 25. <ind the present value for the following income stream if the interest rate is 12 percent. Y38%A 1& 5&10 11&15 $5,001.02 2'. You place $5,000 in .our credit union at an annual interest rate of 12 percent compounded monthl.. Bow much will .ou have in 2 .ears if all interest remains in the accounts/ $',+ 0.50 2*. You have @ust had .our thirtieth "irthda.. You have two children. One will go to college 0 .ears from now and re7uire four "eginning&of&.ear pa.ments for college e#penses of $12,000, $1+,000, $1 ,000, and $15,000. $he second child will go to college 1 .ears from now and re7uire four "eginning&of&.ear pa.ments of $1',000, $1*,000, $10,000, and $1),000. In addition, .ou plan to retire in 25 .ears. You want to "e a"le to withdraw $'0,000 per .ear 2at the end of each .ear5 from an account throughout .our retirement. You e#pect to live 25 .ears "e.ond retirement. $he first withdrawal will occur on .our fift.&si#th "irthda.. ,hat e7ual, annual, end&of&.ear amount must .ou save for each of the ne#t 25 .ears to meet these goals, if all savings earn a 1+ percent annual rate of return/ $ ',5 ' 20. <ind the present value of the cash flows shown using a discount rate of ) percent. Y38% 1&5 ' * 0&1' 1*&20 =8AB<1O, $150C.r. 200 250 150C.r. +00C.r. $ 1,5*'.20 2). 8ccording to a local department store, the store charges customers 1( per month on the outstanding "alances of their charge accounts. ,hat is the effective annual rate on such customer credit/ 8ssume the store recalculates .our account "alance at the end of each month. =8AB<1O, $ 500 $ 000 $1,200

17

12.'0( +0. Your "an> has offered .ou a $15,000 loan. $he terms of the loan re7uire .ou to pa. "ac> the loan in five e7ual annual installments of $ ,1'1.00. $he first pa.ment will "e made a .ear from toda.. ,hat is the effective rate of interest on this loan/ : +1. 12(

You have purchased a new sail"oat and have the option of pa.ing the entire $0,000 now or ma>ing e7ual, annual pa.ments for the ne#t .ears, the first pa.ment due one .ear from now. If .our time value of mone. is * percent, what would "e the largest amount for the e7ual, annual pa.ments that .ou would "e willing to underta>e/ $2,+'2.00

+2.

8 firm purchases 100 acres of land for $200,000 and agrees to remit twent. e7ual annual installments of $ 1,0'* each. ,hat is the true annual interest rate on this loan/ 20 percent

++.

$hirt. .ears ago, Iessie Iohnson "ought ten acres of land for $500 per acre in what is now downtown Bouston. If this land grew in value at a 10 percent per annum rate, what is it worth toda./ $ 0*,2 5

+ .

If .ou put .our mone. in a "an> offering 12 percent compounded 7uarterl., how much will $1,0 grow to in five .ears/ : $1,005.50

+5. +'.

,hat is the future value of $1,250 compounded at an 0 percent rate for ten .ears/ $2,')0.'+ Iames Atreets- son Barold is five .ears old toda.. Barold is alread. ma>ing plans to go to college on his eighteenth "irthda. and his father wants to start putting awa. mone. now for that purpose. Atreet estimates that Barold will need $1 ,000, $15,000, $1',000, and $1*,000 for his freshman, sophomore, @unior, and senior .ears. Be plans on ma>ing these amounts availa"le to Barold at the "eginning of each of these .ears. Atreet would li>e to ma>e twelve deposits 2the first of which would "e made on Barold-s si#th "irthda., 1 .ear from now5 in an account earning 12 percent. Be wants the account to eventuall. "e worth enough to pa. for Barold-s college e#penses. 8n. "alances remaining in the account will continue to earn 12 percent. Bow much will Atreet have to deposit in this planning account each .ear to provide for Barold-s education/ $21'5

+*.

In .our anal.sis of !4E =orporation .ou find that the current earnings per share are $5.00 per share and most anal.sts are pro@ecting the earnings per share to grow at a 12 percent rate annuall.. ,hat can .ou e#pect the earnings per share of this firm to "e in * .ears/

18

$11.0' +0. Your grandmother is thrilled that .ou are going to college and plans to reward .ou at graduation with a ;orsche $ur"o automo"ile. Ahe would li>e to set aside an e7ual amount at the completion of each of .our college .ears from her meager pension. If her account earns 12 percent and a new ;orsche will cost $50,000, how much will she deposit each .ear/ 8ssume her first deposit is in e#actl. one .ear. $10, '2. +). AellDar =orporation currentl. has sales of $100 million and its mar>eting department is pro@ecting sales to "e $000 million in .ears. ,hat rate of growth in sales are the mar>eting people pro@ecting/ '0( 0. Auppose that a local savings and loan association advertises a ' percent annual rate of interest on regular accounts, compounded monthl.. ,hat is the effective annual percentage rate of interest paid ". the savings and loan/ '.1'( 1. Greg ;err., K$3;-s renowned computer @oc>, is graduating in one .ear and plans to start his own computer firm, namel. ;err.-s ;eriphals, Inc. 4eing a science fiction "uff, Greg is planning to start his firm using $50,000 he earned as a trom"one pla.er in the 4its and !iscs IaDD 4and during college and retire in 20 .ears in order to ta>e the first Intergalactic Apace Ahuttle trip at an estimated cost of $10.5 million. ,hen Greg returns to earth 10 .ears thereafter, he plans to live off an annuit. of $+00,000 per .ear, starting on the da. of his return. $his annuit. was funded when he left on his space @ourne. and is earning interest at 12 percent per .ear. 4ut one of the side effects of the space shuttle program has "een that ever. traveler dies e#actl. 20 .ears from the da. of return. =alculate the growth rate of ;err.-s ;eriphals that will ma>e Greg-s long&range plans possi"le. +1.1 percent Iason and 4r.an Ec:utt are presentl. + and 5 .ears old. $heir parents are planning to send them to college at age 10 at a cost of $10,000 per .ear for each. Bow much must the parents contri"ute annuall. to a college fund to ensure the "o.s- college education if the interest rate is 12 percent compounded annuall./ $he pa.ments start in one .ear and end when the .ounger "rother starts college. $2,05* +. If .ou have $5, +' in an account that has "een pa.ing an annual rate of 10(, compounded continuousl., since .ou deposited some funds 10 .ears ago, how much was the original deposit/ $2,000 . <or a 10 .ear deposit, what annual rate pa.a"le semi&annuall. will produce the same effective rate as ( compounded continuousl./

2.

19

.0 percent 5. Bow much should .ou "e willing to pa. for an account toda. that will have a value of $1,000 in 10 .ears under continuous compounding if the nominal rate is 10(/ $+'0 '. Your firm has recentl. "orrowed $100,000 from a local "an> at an interest rate of 10 percent. $he loan is to "e repaid in 5 e7ual, end&of&.ear pa.ments. $he following is a partial amortiDation schedule for the loan. ;rincipal Year ;a.ment Interest %eduction 0 1 $ 2',+00 $ 10,000 $ 1',+00 2 $ 2',+00 $ 0,+'2 $ 8 + $ 2',+00 $ 4 $ 1),020 $ 2',+00 $ ,5*0 $ 21,001 5 $ 2',+00 $ 2,+)0 $ 2+,)01 8. 4alance $ 100,000 $ 0+,'20 $ '5,'02 $ 5,*0+ $ 2+,)01 $ 0

$he missing value for the ;rincipal %eduction in the second .ear 2la"eled 85 is: $ 10,010

4.

$he missing value for the Interest ;a.ment in the third .ear 2la"eled 45 is: $ ',5'0

*.

You are valuing an investment that will pa. .ou $2 ,000 per .ear for the first ' .ears, $20,000 per .ear for the ne#t 10 .ears, and $5 ,000 per .ear the following 1 .ears 2all pa.ments are at the end of each .ear5. If the appropriate annual discount rate is '.00(, what is the value of the investment to .ou toda./ $ '0,0*0 CHAPTER SEVEN PROBLEMS

1..

=alculate the price of a 10 .ear "ond pa.ing a ' percent annual coupon 2half of the ' percent semiannuall.5 on a face value of $1,000 if investors can earn 0 percent on similar ris> investments. $0'+.*0

2.

8 ma@or auto manufacturer has e#perienced a mar>et re&evaluation latel. due to a num"er of lawsuits. $he firm has a "ond issue outstanding with 15 .ears to maturit. and a coupon rate of 0( 2paid semiannuall.5. $he re7uired rate has now risen to 1'(. 8t what price can these securities "e purchased on the mar>et/ $5 ).*1

+.

$he current mar>et price of a Iones- =ompan. "ond is $1,2)*.50. 8 10( coupon interest rate is paid semi&annuall., and the par value is e7ual to $1,000. ,hat is the Y$E 2on an annual "asis5 if the "onds mature 10 .ears from toda./

20

' percent . =ommonwealth =ompan. has 100 "onds outstanding 2maturit. value H $1,0005. $he re7uired rate of return on these "onds is currentl. 10(, and interest is paid semiannuall.. $he "onds mature in 5 .ears, and their current mar>et value is $*'0 per "ond. ,hat is the annual coupon interest rate/ ( percent 5. You have @ust "een offered a "ond for $0 *.00. $he coupon rate is 0(, pa.a"le annuall., and interest rates on new issues of the same degree of ris> are 10(. You want to >now how man. more interest pa.ments .ou will receive, "ut the part. selling the "ond cannot remem"er. =an .ou help him out/ 15 '. <ord and GE have similar "ond issues outstanding. $he <ord "ond has interest pa.ments of $00 paid annuall. and matures in the .ear 2002 220 .ears from toda.5. $he GE "ond has interest pa.ments of $00 paid semiannuall. and also matures in the .ear 2002. If the re7uired rate of return 2>d5 is 12(, what is the difference in current selling price of the two "onds/ $2.10 *. 8cme ;roducts has a "ond outstanding with 0 .ears remaining to maturit. and a coupon rate of 5( paid semiannuall.. If the current mar>et price is $*2).05, what is the .ield to maturit./ 10 percent

0.

%ecentl., $13, Inc., filed "an>ruptc. papers. $he firm was reorganiDed as !1, Inc., and the court permitted a new indenture on an outstanding "ond issue to "e put into effect. $he issue has 10 .ears to maturit. and a coupon rate of 10(, paid annuall.. $he new agreement allows the firm to pa. no interest for 5 .ears and then at maturit. to repa. principal and an. unpaid interest 2no interest on the unpaid interest5. If the re7uired return is 20(, what should such "onds sell for in the mar>et toda./ $+'2.

).

In order to assess accuratel. the capital structure of a firm, it is necessar. to convert the "alance sheet to a mar>et value "asis. $he current "alance sheet is as follows: 1ong&term de"t 2"onds5 ;referred stoc> =ommon stoc> 2$10 par5 %etained earnings $otal de"t and e7uit. $10,000,000 2,000,000 10,000,000 ,000,000 &&&&&&&&&&& $2',000,000

$he "onds mature in 10 .ears. Interest is pa.a"le semiannuall. and the .ield to maturit.

21

is 12(. $he coupon rate is de"t/

percent. ,hat is the current mar>et value of the firm-s

$5. 12 million 10. =alculate the .ield to maturit. 2on an annual "asis5 of an 0 percent coupon, 10&.ear "ond that pa.s interest semiannuall. if its price is now $**0.'0. 12 percent 11. You are the owner of 100 "onds issued ". Eidterm =orporation. $hese "onds have 0 .ears remaining to maturit., an annual coupon pa.ment of $00, and a par value of $1,000. Knfortunatel., Eidterm is on the "rin> of "an>ruptc., and the creditors, including .ourself, have agreed to a postponement of the ne#t interest pa.ments. $he remaining interest pa.ments will "e made as scheduled. $he postponed pa.ments will accrue interest at an annual rate of '( and will "e paid as a lump sum at maturit. 0 .ears hence. $he re7uired rate of return on these "onds, considering their su"stantial ris>, is now 20(. ,hat is the present value of each "ond/ $2''.0) 12. $he ?YR =ompan. recentl. issued a 20&.ear, * percent semiannual coupon "ond at par. 8fter three months, the mar>et interest rates on similar "onds increased to 0 percent. 8t what price should the "onds sell/ $)10.00 1+. I4? has a "ond issue outstanding that is calla"le in three .ears at a 5 percent call premium. $he "ond pa.s a 10 percent annual coupon and has a remaining maturit. of 2+ .ears. If the current mar>et price is $1000, than what is the .ield to call/ 11. 0 percent CHAPTER EIGHT PROBLEMS 1. $he !8; =ompan. has decided to ma>e a ma@or investment. $he investment will re7uire a su"stantial earl. cash out&flow, and inflows will "e relativel. late. 8s a result, it is e#pected that the impact on the firm-s earnings for the first 2 .ears will "e a negative growth of 5( annuall.. <urther, it is anticipated that the firm will then e#perience 2 .ears of Dero growth after which it will "egin a positive annual sustaina"le growth of '(. If the firm-s cost of capital is 10( and its current dividend 2! 05 is $2 per share, what should "e the current price per share/ $+0. * 2. $he %adle. =ompan. has decided to underta>e a large new pro@ect. =onse7uentl., there is a need for additional funds. $he financial manager decides to issue preferred stoc> which has a stated dividend of $5 per share and a par value of $+0. If the re7uired return on this stoc> is currentl. 20(, what should "e the stoc>-s current mar>et value/ $25

22

+.

A:G-s stoc> is selling for $15 per share. $he firm-s income, assets, and stoc> price have "een growing at an annual 15( rate and are e#pected to continue to grow at this rate for + more .ears. :o dividends have "een declared as .et, "ut the firm intends to declare a $2.00 dividend at the end of the last .ear of its supernormal growth. 8fter that, dividends are e#pected to grow at the firm-s normal growth rate of '(. $he firm-s re7uired rate of return is 10(. You should: Aell the stoc>6 it is overvalued ". $+.0+.

44;, Inc., has e#perienced a recent resurgence in "usiness as it has gained new national identit.. Eanagement is forecasting rapid growth over the ne#t .ears 2annual rate of 15(5. 8fter that, it is e#pected that the firm will revert to its historical growth rate of 2( annuall.. $he last dividend paid was $1.50 per share, and the re7uired return is 10(. ,hat is the current price per share, assuming e7uili"rium/ $2).51

5.

$he =lu" 8uto ;arts =ompan. has @ust recentl. "een organiDed. It is e#pected to e#perience no growth for the ne#t 2 .ears as it identifies its mar>et and ac7uires its inventor.. Bowever, =lu" will grow at an annual rate of 5( in the third and fourth .ears and, "eginning with the fifth .ear, should attain a 10( growth rate which it will sustain thereafter. $he last dividend paid was $0.50 per share. =lu" has a cost of capital of 12(. ,hat should "e the present price per share of =lu" common stoc>/ $20.0

'.

8 share of !%F, Inc., stoc> paid a dividend of $1.50 last .ear, and the dividend is e#pected to grow at a constant rate of ( in the future. $he appropriate rate of return on this stoc> is "elieved to "e 12(. ,hat should the stoc> sell for toda./ $1).50 $he ;et =ompan. has recentl. discovered a t.pe of roc> which, when crushed, is e#tremel. a"sor"ent. It is e#pected that the firm will e#perience 2"eginning now5 an unusuall. high growth rate 220(5 during the period 2+ .ears5 when it has e#clusive rights to the propert. where this roc> can "e found. Bowever, "eginning with the fourth .ear the firm-s competition will have access to the material, and from that time on the firm will assume a normal growth rate of 0( annuall.. !uring the rapid growth period, the firm-s dividend pa.out ratio will "e relativel. low 220(5, to conserve funds for reinvestment. Bowever, the decrease in growth will "e accompanied ". an increase in dividend pa.out to 50(. 1ast .ear-s earnings were $2.00 per share 23 05 and the firm-s cost of e7uit. is 10(. ,hat should "e the current price of the common stoc>/ $*1.'0

*.

0.

I$JE, Inc., a large conglomerate, has decided to ac7uire another firm. 8nal.sts are forecasting that there will "e a period 22 .ears5 of e#traordinar. growth 220(5 followed ". another 2 .ears of unusual growth 210(5, and that finall. the previous growth pattern of '( annuall. will resume. If the last dividend was $1 per share and the re7uired return is 0(, what should the mar>et price "e toda./ $*+.*

23

).

8 share of !%F, Inc., stoc> paid a dividend of $1.50 last .ear, and the dividend is e#pected to grow at a constant rate of ( in the future. $he appropriate rate of return on this stoc> is "elieved to "e 12(. Auppose !%F stoc> were selling for $25 toda.. ,hat would "e the implied value of >s , assuming the other data remain the same/ 10.2 percent

10.

$he =anning =ompan. has "een hit hard due to increased competition. $he compan.-s anal.sts predict that earnings 2and dividends5 will decline at a rate of 5( annuall. into the foreseea"le future. 8ssume that > s H 11( and !0 H $2.00. ,hat will "e the price of the compan.-s stoc> in three .ears/ $10.1)

11.

I4E is currentl. selling at $'5 per share. :e#t .ear-s dividend is e#pected to "e $2.'0. If investors on this particular da. e#pect a return of 12( on their investment, what do the. thin> I4E-s growth rate will "e/ 0 percent

12.

$he EE =ompan. has fallen on hard times. Its management e#pects to pa. no dividends for the ne#t 2 .ears. Bowever, the dividend for Year + 2! +5 will "e $1.00 per share, and it is e#pected to grow at a rate of +( in Year , '( in Year 5, and 10( in Year ' and thereafter. If the re7uired return for EE =o. is 20(, what is the current e7uili"rium price of the stoc>/ $'.+

1+.

Your "rother&in&law, a stoc>"ro>er at Invest, Inc., is tr.ing to sell .ou a stoc> with a current mar>et price of $20. $he stoc> had a last dividend 2!05 of $2.00 and a constant growth rate of 0(. Your re7uired return on this stoc> is 20(. <rom a strict valuation standpoint, .ou should: :ot "u. the stoc>6 it is overvalued ". $2.00.

1 .

:egative 1imited is e#pected to grow for four .ears at a rate of 50 percent. 8fter four .ears, the product fad is e#pected to decline, and :egative will grow at a negative growth rate of 5 percent. :egative currentl. pa.s a dividend of $1.00 per share and stoc>holders have a re7uired rate of return of 10 percent. ,hat should "e the mar>et value for a share of :egative 1imited stoc>/ $10.+

15.

8ssume the firm has "een growing at a 15( annual rate and is e#pected to continue to do so for + more .ears. 8t that time, growth is e#pected to slow to a constant ( rate. $he firm maintains a +0( pa.out ratio, and this .ear-s retained earnings were $1. million. $he firm-s "eta is 1.25, the ris>&free rate is 0(, and the mar>et ris> premium is (. If the mar>et is in e7uili"rium, what is the mar>et value of the firm-s common e7uit. 21 million shares outstanding5/

24

$).1' million 1'. !e#ter, Inc., has @ust paid a dividend of $2.00. Its stoc> is now selling for $ 0 per share. $he firm is half as volatile as the mar>et. $he e#pected return on the mar>et is 1 ( and the .ield on K.A. $reasur. "onds is 11(. If the mar>et is in e7uili"rium, what rate of growth is e#pected/ 0 percent 1*. Given the following information, calculate the e#pected capital gains .ield for 4imlo 4ottle =aps6 "eta H 0.'6 >m H 15(6 %f H 0(6 !1 H $2.006 ;0 H $25.00. 8ssume the stoc> is a constant growth stoc> and is in e7uili"rium. .2 percent 10. ?YR stoc> is currentl. pa.ing a dividend of $2.00 per share 2!0 H $25 and is in e7uili"rium. $he compan. has a growth rate of 5( and "eta e7ual to 1.5. $he re7uired rate of return on the mar>et is 15(, and the ris>&free rate is *(. ?YR is considering a change in polic. that will increase its "eta coefficient to 1.*5. If mar>et conditions remain unchanged, what new growth rate will cause the common stoc> price of ?YR to remain unchanged/ '.*' percent 1). Knion ;aper-s stoc> is currentl. in e7uili"rium selling at $+0 per share. $he firm has "een e#periencing a '( annual growth rate. 3arnings per share 23 05 were $ .00 and the dividend pa.out ratio is 0(. $he ris>&free rate is 0( and the mar>et ris> premium is 5(. If s.stematic ris> increases ". 50(, all other factors remaining constant, the stoc> price will increaseCdecrease ".: &$*.+1 20. =harter Oil =ompan. is currentl. selling at its e7uili"rium price of $100 per share. $he "eta coefficient currentl. is 2. $he ris>&free rate is 10(. $he following events will soon occur: 215 top management will lower =harter-s "eta to 1.2 ". investing in several low ris> pro@ects6 225 the <ederal %eserve 4oard will reduce the mone. suppl. causing the inflation premium to "e reduced ". + percentage points6 and 2+5 decreased world sta"ilit. due to glo"al politics will cause the mar>et ris> premium to increase 2 percentage points to 5(. $he compan. has a constant growth rate of 5(. ,hat will "e the new e7uili"rium price for a share of =harter Oil common stoc> after the a"ove events have ta>en place/ 28ssume the e#pected dividend will not change.5 $1+*.50 21. ,heeler, Inc., is presentl. in a stage of a"normall. high growth "ecause of the e#cess demand for widgets. $he compan. e#pects earnings and dividends to grow at a rate of 20( for the ne#t .ears, after which time there will "e no growth in earnings and dividends. $he compan.-s last dividend was $1.50. ,heeler has a "eta of 1.', the return on the mar>et is currentl. 12.*5(, and the ris>&free rate is (. ,hat should "e the current price per share of common stoc>/ $15.1*

25

22. You are given the following data: 1. 2. +. . 5. $he ris>&free rate is 0.05. $he re7uired return on the mar>et is 0.00. $he e#pected growth rate for the firm is 0.0 . $he last dividend paid was $0.00 per share. 4eta is 1.+.

:ow assume the following changes occur: 1. 2. +. . $he inflation premium decreases ". the amount of 0.01. 8n increased degree of ris> aversion causes the re7uired return on the mar>et to go to 0.10 after ad@usting for the changed inflation premium. $he e#pected growth rate increases to 0.0'. 4eta rises to 1.5.

,hat will "e the change in price per share assuming the stoc> was in e7uili"rium "efore the changes/ &$ .0* 2+. You are considering "u.ing common stoc> in Grow On, Inc. You have calculated that the firm-s free cash flow was $*.'0 million last .ear. You pro@ect that free cash flow will grow at a rate of 5.0( per .ear indefinitel.. $he firm currentl. has outstanding de"t and preferred stoc> with a total mar>et value of $22.2+ million. $he firm has 2.) million shares of common stoc> outstanding. If the firm-s cost of capital is 1).0(, what is the most .ou should pa. per share for the stoc> now/ $11.0+ 2 . !ue to the highl. specialiDed nature of the electronic industr., 4orrett Industries invest a lot of mone. in %J! on prospective products. =onse7uentl., it retains all of its earning and reinvests them into the firm. 8t this time, 4orrett does not an. plans to pa. dividends in the near future. 8 ma@or pension fund is interested in purchasing 4orrett-s stoc>, which is traded on the :YA3. $he treasurer for the pension fund has done research on the compan. and has estimated 4orrett-s free cash flow for the ne#t four .ears as follows: $+ million, $' million, $10 million and $15 million. 8fter the fourth .ear, free cash flow is pro@ected to grow at a constant * percent. 4orrett-s ,8== is 12 percent, it has $'0 million of total de"t and preferred stoc> and 10 million shares of common stoc>. 8. ,hat is the present value of 4orrett-s free cash flows during the ne#t four .ears/ $2 ,112,+00 ,hat is the compan.-s terminal value/ $+21,000,000 =. ,hat is the total value of the firm toda./ $220,11+,'12

4.

26

!.

,hat is 4orrett-s price per share/ $1'.01

25.

8ssume that toda. is !ecem"er +1, 2000 and that the following information applies to Fermeil 8irlines: 8. 4. =. !. 3. <. G. B. I. 8fter&ta# operating income S34I$21&t5T for 2001 is e#pected to "e $500 million. $he compan.-s depreciation e#pense for 2001 is e#pected to "e $100 million. $he compan.-s capital e#penditures for 2001 are e#pected to "e $200 million :o change is e#pected in the compan.-s net operating wor>ing capital. $he compan.-s free cash flow is e#pected to grow at a constant rate of ' percent per .ear. $he compan.-s cost of e7uit. is 1 percent. $he compan.-s ,8== is 10 percent. $he mar>et value of the compan.-s de"t is $+ "illion. $he compan. has 200 million shares of stoc> outstanding.

Ksing the free cash flow approach, what should the compan.-s stoc> price "e toda./ $+5.00 per share

CHAPTER NINE PROBLEMS 1. $he chief financial officer of ;ortland Oil has given .ou the assignment of determining the firm-s marginal cost of capital. $he present capital structure which is considered optimal, is: 4oo> Falue Ear>et Falue !e"t $ 50 million $ 0 million ;referred Atoc> 10 million 5 million =ommon 37uit. +0 million 55 million $otal $ )0 million $ 100 million $he anticipated financing opportunities are these: !e"t can "e issued with a 15 percent "efore&ta# cost. ;referred stoc> will "e $100 par, carr. a dividend of 1+ percent, and can "e sold to net the firm $)' per share. =ommon e7uit. has a "eta of 1.20, the return on the mar>et is 1* percent, and the ris>&free rate is 12 percent. If the firm-s ta# rate is 0 percent, what is its marginal cost of capital/ 1 .2 percent 2. Ailicon =orp. recentl. issued 10&.ear, 12 percent coupon "onds at par value. Ailicon-s

27

"eta is 0.'6 the optimal capital structure contains 5 percent de"tC55 percent e7uit.6 and the marginal ta# rate is 0 percent. If the e#pected return on the mar>et is 1' percent and the treasur. "ill rate is ) percent, estimate Ailicon-s weighted average cost of capital. 10.5 percent +. Iefferson re7uires $15 million to fund its current .ear9s capital pro@ects. Iefferson will finance part of its needs with $) million in internall. generated funds. $he firms9 common stoc> mar>et price is $120 per share. $he firm9s last dividends was $5 per share and is e#pected to grow at a rate of 11 percent annuall. for the foreseea"le future. 8nother portion of the re7uired funds will come from the issue of ),+*5 shares of 12 percent $100 par preferred stoc> that will "e privatel. placed. $he firm will net $)' per share from the sale of these shares. $he remainder of the funding needs will "e met with de"t. <ive thousand 10&.ear $1,000 par "onds with a coupon rate of 15 percent will "e issues to net the firm $1,020 each. Interest will "e paid annuall. on the "onds. $he firm9s ta# rate is +0 percent. 1+.'1 percent . 8verage =orporation-s stoc> currentl. sells for $ 5.00 per share, it is e#pected to pa. a dividend of $+.10 ne#t .ear, its growth rate is a constant *.0(, and the compan. will incur a flotation cost of 12.0( of the mar>et value if it sells new common stoc>. $he firm-s ta# is 0(. ,hat is the firm-s cost of retained earnings/ 1+.0)(

5.

You are determining ?YR, Inc.-s optimal capital "udget for the ne#t .ear. You have identified the following possi"le I:!IFIAI413 capital pro@ects: ;%OI3=$ =OA$ 8 $ 100,000 4 000,000 = 500,000 ! +00,000 3 00,000 < *00,000 G '00,000 I%% 1' ( 1 ( 10 ( 15 ( 12 ( 1* ( 20 (

?YR-s marginal cost of capital is: :3, =8;I$81 %3UKI%3! $ 0 & 500,000 $ 500,001 & ))),))) $ 1,000,000 & 1, )),))) $ 1,500,000 & 1,))),))) $ 2,000,000 & 2, )),))) $ 2,500,000 & +,000,000 84OF3 $ +,000,000 E8%GI:81 =OA$ 1+.0 ( 1 .2 ( 15.0 ( 15.5 ( 1*.0 ( 1*.5 ( 10.0 (

28

,hat is ?YR-s optimal capital "udget for the upcoming .ear/ $1.) million '. Earginal Incorporated has determined that its "efore&ta# cost of de"t is 10.0(. Its cost of preferred stoc> is 11.0(. Its cost of internal e7uit. is 15.0(, and its cost of e#ternal e7uit. is 1'.)(. =urrentl., the firm-s capital structure consists of +2( de"t, 1 ( preferred stoc>, and 5 ( common e7uit.. $he firm-s marginal ta# rate is +)(. ,hat is the firm-s weighted average cost of capital if it will have to issue new common stoc> to fund the e7uit. portion of its capital "udget/ 12.'2 percent

29

CHAPTER TEN PROBLEMS 1. 8n insurance firm agrees to pa. .ou $+,+01 at the end of 20 .ears if .ou pa. premiums of $100 per .ear at the end of each .ear of the 20 .ears. <ind the internal rate of return. 8nswer: 5 percent 2. $he capital "udgeting director is evaluating a pro@ect that costs $200,000, is e#pected to last for 10 .ears and to produce after&ta# income of $2),50+ per .ear. !epreciation applica"le to this pro@ect would "e $20,000 per .ear. If the cost of capital of the firm is 1 (, what is the pro@ect-s I%% 2ta# rate H 0(5/ 21.1 percent +. Given the following net cash flows, determine the I%% of the pro@ect: $ime &&&& 0 1 2 + 2 ( . 8cme ;roducts, Inc., re7uires a new machine to produce a part for a heat generator. $wo companies have su"mitted "ids, and .ou have "een assigned the tas> of choosing one of the machines. =ash flow anal.sis indicates the following: Year &&&& 0 2 + Eachine 8 &&&&&&&&& &$1,000 0 0 0 1,)+0 Eachine 4 &&&&&&&&& &$1,000 1* 1* 1* 1* :et cash flow &&&&&&&&&&&&& $ 1,520 &1,000 &1,500 500

8.

,hat is the internal rate of return for each machine/ I%%8 H 0.106 I%%4 H 0.2

4.

If the cost of capital for 8cme ;roducts is 5(, which of the following is true/ $he :;F8 V :;F4 , therefore accept Eachine 8.

5.

;ro@ects = and , are mutuall. e#clusive, and the. have the following net cash flows:

30

Year &&&& 0 1 2 + 5

;ro@ect = &&&&&&&&& &$50,000 +0,000 0,000 50,000 0 0

;ro@ect , &&&&&&&&& &$100,000 0,000 0,000 0,000 0,000 0,000

You are to use the e7uivalent annual annuit. method for comparing these pro@ects since the. have une7ual lives. $he cost of capital is 10(. ,hich pro@ect should "e chosen/ ;ro@ect = since it has a higher e7uivalent annual annuit.. '. $he Amith =ompan. is considering two mutuall. e#clusive investments that would increase its capacit. to ma>e straw"err. tarts. $he firm uses a 12 percent cost of capital to evaluate potential investments. $he pro@ects have the following costs and cash flow streams: Y38% 0 1 2 + 5 ' * 0 81$3%:8$IF3 8 81$3%:8$IF3 4 $ &+0,000 $ &+0,000 10,500 ',500 10,500 ',500 10,500 ',500 10,500 ',500 && ',500 && ',500 && ',500 && ',500

,hat are the respective 3UKIF813:$ 8::K81 8::KI$I3A for alternatives 8 and 4/ 81$3%:8$IF3 8 81$3%:8$IF3 4 : $ '21.+5 $ '1.+5 *. ,hat is the pa."ac> period, the :;F at a discount rate of 10 percent, and the I%% for a pro@ect with the following cash flows/ Y38% 0 1 2 + =8AB OK$<1O, $ 1000 && && && ;8Y48=M 1 5C' .rs 0. =8AB I:<1O, && $ 500 '00 10' I%% 12 (

:;F +0

8 pro@ect has an initial cost of $), 2*. If it returns a net cash flow of $1,000 at the end of each .ear for the ne#t +0 .ears, the internal rate of return must "e: 10 ( ,hat is the I%% of a pro@ect with the following cash flows/

).

31

$IE3 0 1 2 + 5

=8AB OK$<1O, $ +,2)5 && && && && && 5(

=8AB I:<1O,A && $ 10,000 10,000 10,000 10,000 10,000

10.

Your compan. is considering two mutuall. e#clusive pro@ects, ? and Y, whose costs and cash flows are shown "elow: Year ? Y 0 &$1,000 &$1,000 1 100 1,000 2 +00 100 + 00 50 *00 50 $he pro@ects are e7uall. ris>., and their cost of capital is 12 percent. ,hat is the modified I%% of each pro@ect/ ? Y 1+.5)( 1+.10(

11.

=onglomerates, Inc., is considering the purchase of Amall J =ompan.. $he ac7uisition would re7uire an initial investment of $1)0,000, "ut =onglomerates- net cash flows would increase ". $+0,000 per .ear and remain at the new level forever. Ahould =onglomerates "u. Amall/ 8ssume a cost of capital of 15(. Yes, "ecause the :;F H $10,000.

12.

If the re7uired rate of return is 12 percent, what is the net present value of the pro@ect descri"ed "elow: =OA$ O< :3, 3UKI;E3:$ $ '0,000 1I<3 O< 3UKI;E3:$ ' Y38%A A81F8G3 F81K3 $ ',000 8::K81 :3$ =8AB <1O, $ 12,000 $ &*,'2

1+. ,hat is the I%% of a pro@ect with the following cash flows/ Y38% 0 1 2 + 5 =8AB<1O, $ 0 $ 0 $ &2500 $ 1000 $ 1000 $ 1000

)&10 ( 1 . ,hat is the net present value of this investment/

32

I:I$I81 =OA$ $ 15,000 ;%OI3=$ 1I<3 5 .ears A81F8G3 F81K3 $ 0 8::K81 :3$ =8AB <1O,A $ 5,000 !IA=OK:$ %8$3 10 ( $ +,)5 .00 15. If a capital "udgeting pro@ect has an initial outla. of $1,500 and an :;F of $5,000, what is its profita"ilit. inde#/ .++ 1'. =ummings ;roducts =ompan. is considering two mutuall. e#clusive investments. $he pro@ect-s e#pected net cash flows are as follows: Year 0 1 2 + 5 ' * 8. 3#pected :et =ash <lows ;ro@ect 8 ;ro@ect 4 2$+005 2$ 055 2+0*5 1+ 21)+5 1+ 21005 1+ '00 1+ '00 1+ 050 1+ 21005 0

If the cost of capital for each pro@ect is 12 percent, what is the :;F for each pro@ect/ ,hich pro@ect should "e accepted/ $200. 1 and $1 5.)+ ;ro@ect 8

4.

If the cost of capital for each pro@ect is 10 percent, what is the :;F for each pro@ect/ ,hich pro@ect should "e accepted/ $2.'' and $'+.'0 ;ro@ect 4

=. ,hat is the internal rate of return for each pro@ect/ 10.1( and 2 .0( !. ,hat is the crossover rate/ 1 .5+(

33

CHAPTER ELEVEN PROBLEMS 1. EJE Inc., is considering the purchase of a new machine which will reduce manufacturing costs ". $5,000 annuall.. EJE will use the straight&line method to depreciate the machine, and it e#pects to sell the machine at the end of its 5 .ear life for $10,000. $he firm e#pects to "e a"le to reduce wor>ing capital ". $15,000 when the machine is installed. $he firm-s marginal ta# rate is 0( and it uses a 12( cost of capital to evaluate pro@ects of this nature. If the machine costs $'0,000, what is the :;F of the pro@ect-s cash flows/ &$22,'0 2. 4la>e =orporation-s new pro@ect calls for an investment of $10,000. It has an estimated life of 10 .ears. $he I%% has "een calculated to "e 15(. If cash flows are evenl. distri"uted and the ta# rate is 0(, what is the annual 43<O%3&$8? cash flow each .ear/ 28ssume depreciation is a negligi"le amount.5 $+,+21 +. G Eart, Inc., is considering the ac7uisition of e7uipment to e#pand its sales. $he initial cost of the e7uipment is $100,000. Bowever, the production manager has estimated the e#pansion program will increase cash operating costs ". $20,000. 8ssume straight line depreciation to a Dero salvage value, a ta# rate of 0(, and a cost of capital of 10(. Bow much will the additional cash revenue during the 10 .ear life of the asset have to "e to cause the I%% of the pro@ect to "e e7ual to >/ $ 0, 5* . 4lain =orporation is considering the purchase of a machine which has an e#pected 0 .ear life and costs $20,000. $he annual e#pected :3$ =8AB <1O, from the machine is $5,000 for the first * .ears and $),000 in .ear 0, e#cluding salvage values. $he asset will "e depreciated on a straight line "asis to a $ ,000 salvage value. It is eligi"le for a *( investment ta# credit. If the discount rate is 10(, what is the machine-s :;F/ $11,00* 5. ;recision Eetals, Inc. is considering the replacement for its e#isting lathe, which cost $200,000 at the time of purchase five .ears ago, and which now has a remaining life of five .ears with no salvage value. It can "e sold currentl. for $100,000. 8 new, more operationall. efficient lathe costs $+00,000 and has a useful life of five .ears with a salvage value of $50,000. It is e#pected to reduce operating costs ". $'',000 annuall.. 8n investment ta# credit of 10 percent of the purchase price can "e used if the lathe is ac7uired. $he firm-s re7uired rate of return for replacement decisions is 12 percent. 8ssume straight&line depreciation and a ta# rate of 0 percent. $he net present value of this capital "udgeting decision is: $ ,+00

34

'.

=!4 J 8ssociates is considering the purchase of a new piDDa oven. $he original cost of the old oven was $+0,000. $he machine is now 5 .ears old and has a current mar>et value of $5,000. $he oven is "eing depreciated over a 10&.ear life toward a Dero estimated salvage value on a straight&line "asis. Eanagement is contemplating the purchase of a new oven whose cost is $25,000 and whose estimated salvage value is Dero. 3#pected cash savings from the new oven are $2,000 a .ear 2"efore ta#5. !epreciation is on a straight&line "asis over a 5 .ear life, and the cost of capital is 10(. 8ssume a 50( ta# rate. ,hat is the net present value of the new machine/ &$*, 10

*.

Aandals, Inc., is considering the purchase of a new leather&cutting machine to replace an e#isting machine that has a "oo> value of $+,000 and can "e sold for $1,500. $he estimated salvage value of the old machine in .ears is Dero. $he new machine will reduce costs 2"efore ta#5 ". $*,000 per .ear6 that is, $*,000 cash savings over the old machine. $he new machine has a .ear life, cost $1 ,000, and can "e sold for an e#pected $2,000 at the end of the fourth .ear. 8ssuming straight line depreciation for "oth machines, a 0( ta# rate, and a cost of capital of 1'(, find the :;F. $+, *5

0.

Given the following information, what is the effective cost of the new machine6 that is, what is the cash flow at t H 0/ ;urchase price of new machine Installation charge Ear>et value of old machine 4oo> value of old machine Inventor. decrease if new machine is installed 8ccounts pa.a"le increase if new machine is installed $a# rate 0( =ost of capital 15( $',)00 $0,000 2,000 2,000 1,000 1,000 500

).

Uui>, Inc., is a fast&food esta"lishment that needs to purchase new fr.olators. If the machines are purchased, the. will replace old machines purchased 10 .ears ago for $100,000, "eing depreciated on a straight line "asis to a Dero salvage value 220 .ears deprecia"le life5. $he old machines can "e sold for $120,000. $he new machines will cost $200,000 installed and will "e depreciated on a straight&line "asis to a Dero salvage value in 10 .ears. It is e#pected that there will "e increased revenues of $10,000 per .ear and increased cash e#penses of $2,500 per .ear. If the firm-s cost of capital 2>5 is 10(, the ta# rate on ordinar. income is 0(, and the ta# rate on capital gains is +0(, what is the :;F of the machine/ &$',)00

10.

;=, Inc., has a stamping machine which is 5 .ears old and which is e#pected to last

35

another 10 .ears. It has a "oo> value of $100,000 and is "eing depreciated ". the straight&line method to Dero. $ri&Atate Industries has demonstrated a new machine with an e#pected useful life of 10 .ears 2scrap value $50,0005 that should save ;= $15,000 a .ear in la"or and maintenance costs. If ;=-s cost of capital is 10(, should the replacement "e made/ ;=-s ta# rate is 0(, the new machine will cost $200,000, and an investment ta# credit of 10( applies. $he mar>et value of the old machine is $10,000 and a $10,000 increase in wor>ing capital will "e needed to support the new machine. :o6 :;F H &$5+,2*0 11. GIGO, Inc., is considering replacing its current computer with a new generation model. $he 84E salesperson has demonstrated a model which would cost GIGO $*50,000, should last 10 .ears, and reduce costs $1'',0 + per .ear. 84E estimates that this new computer can "e sold for $10,000 at the end of its useful life. $he computer GIGO currentl. uses has a "oo> value of $ 50,000 2remaining life of 10 .ears, a salvage value of $10,000, and a current mar>et value of $10,000. If an investment ta# credit of 10( is applica"le to the new computer, and the new machine will permit a $10,000 decrease in wor>ing capital when the computer is installed, what is the :;F 2> H 15(, t H 0(, depreciation is straight line5/ $*0,*5+ 12. You have "een as>ed ". the firm-s president to evaluate the proposed ac7uisition of a new machine. $he machine-s price is $50,000, and it will cost $10,000 to transport and install. It will "e depreciated ". the straight&line method over its 5&.ear useful life to a $10,000 salvage value. $he machine will increase revenues ". $10,000 per .ear, and it will decrease operating costs ". $20,000 per .ear. 8lso, the machine will allow the firm to reduce inventories ". $5,000. $he new machine 2including deliver. and installation costs5 7ualifies for a 10( investment ta# credit. If the firm-s cost of capital is 12(, and its marginal ta# rate is 0(, what is the new machine-s :;F/ $++,1 + 1+. Knion 4ric>, Inc., has an electric >iln which is 5 .ears old and is e#pected to last another 10 .ears. It has a "oo> value of $100,000, and it is "eing depreciated ". the straight&line method to a Dero salvage value. 8s !irector of =apital 4udgeting, .ou are evaluating a new gas >iln that should save K4I $25,000 a .ear in fuel costs. $he new >iln would cost $200,000, and it is eligi"le for a 10( investment ta# credit. It would "e depreciated over 10 .ears ". the straight&line method to a $20,000 salvage value. $he mar>et value of the old >iln is $10,000. K4I-s marginal ta# rate is 0(, and the firm-s cost of capital is 10(. ,hat is the :;F of the replacement pro@ect/ &$1 , 50

1 .

8 compan. is planning to invest $50,000 2"efore ta#5 in a personnel training program.

36

$he $50,000 outla. will "e charged off as an e#pense ". the firm this .ear 2time 05. the returns from the program, in the form of greater productivit. and a reduction in emplo.ee turnover, are estimated as follows 2on an after&ta# "asis5: Y38%A 1&10 Y38%A 11&20 $ 5,000 per .ear $ 15,000 per .ear

$he compan. has estimated its cost of capital to "e 15 percent. 8ssume that the entire $50,000 is paid at time 0 2the "eginning of the pro@ect5. $he marginal ta# rate for the firm is 0 percent. ,hat is the investment-s :;F/ $ 1+,')0 15. $he ,%8:G13% =orporation is considering the ac7uisition of a new splicing machine to improve the efficienc. of its clothing operations. $he new machine will cost $'0,000 plus installation costs of $5,000. $he machine-s efficienc. will create additional output6 thus, revenues will increase ". $5,000 annuall.. $he amount of wasted material will decline, so operating costs will decline ". $2,000 annuall.. $he machine will re7uire a $2,000 increase in inventor. and spare parts. $he machine-s estimated salvage value 2at the end of its 5 .ear life5 is $500. 2Kse this value for depreciation purposes.5 $he firm-s marginal ta# rate is 0 percent and its re7uired rate of return is 10 percent. 8ssume that the firm uses straight&line depreciation for anal.sis of this t.pe. 8. ,hat is the :3$ =OA$ of the machine/ 2$hat is, what is the initial cash outflow/5 $ &'*,000 4. ,hat are the net operating cash flows for Year 1 through 5/ $ ),+'0 =. ,hat is the total value of the additional considerations at the end of the five .ears/ $ 2,500 !. ,hat is the :et ;resent Falue of the decision/ $ &2),)''

37

1'.

$he :elson 37uipment =ompan. purchased a machine 5 .ears ago at a cost of $200,000. $he machine had an e#pected life of 10 .ears at the time of the purchase and an e#pected salvage value of $50,000 at the end of the 10 .ears. It is "eing depreciated ". the straight&line method toward a salvage value of $50,000, or ". $15,000 per .ear. 8 new machine can "e purchased for $ 00,000 and re7uire an additional $15,000 in installation costs. $he new machine will re7uire $20,000 in additional spare parts. !uring its 5&.ear life, it will reduce cash operating e#penses ". $150,000 per .ear. Aales are not e#pected to change. 8t the end of its useful life, the machine is estimated to "e worth $50,000. 8=%A depreciation will "e used, and the machine will "e depreciated over its +&.ear class life rather than its 5&.ear economic life. $he old machine can "e sold toda. for $1*5,000. $he firm-s ta# rate is 0 percent and the appropriate discount rate is 12 percent. 2$he recover. allowance percentages for +&.ear propert. are ++(, 5(, 15(, and *(.5 8. ,hat is the :3$ =OA$ of the machine/ 2$hat is, what is the initial cash outflow/5 $ &200,000 4. ,hat are the net operating cash flows for Year 1 and 2/ Year 1 $ 1+0,*00 =. Year 2 $ 150,*00

,hat is the total value of the additional considerations at the end of the five .ears/ $ 0

!.

,hat is the :et ;resent Falue of the replacement decision/ $ 15',+*0

38

1*.

Eac!ougal-s is a fast&food esta"lishment that needs to purchase new fr.olators. If the new fr.olators are purchased, the. will replace old machines purchased 10 .ears ago for $150,000. $he old machines are "eing depreciated on a straight&line "asis to a Dero salvage value. $he original estimated life of the old machines was fifteen .ears. 2$he old machines have five .ears of estimated life remaining.5 $he old fr.olators can currentl. "e sold to another firm in the industr. for $ 0,000. $he new machines will cost $250,000 plus an additional $20,000 for installation. $he new fr.olators have an estimated useful life of five .ears and have an estimated salvage value 2A=%8;5 at the end of five .ears of $10,000. $he new fr.olators have e#tra capacit. and will, thus, increase revenues ". $'0,000 annuall.. $he machines will also reduce operating e#penses 2electricit.5 ". $10,000 annuall.. $he firm will re7uire $5,000 in additional wor>ing capital to support the increased output. Eac!ougal-s depreciates their capital improvements at the ma#imum rate allowed ". the I%A. <or propert. of this t.pe 2+&.ear5, the E8=%A rates are ++(, 5(, 15( and *(. $he firm-s marginal ta# rate is 0 percent and their re7uired rate on pro@ects of this nature is 12 percent. 8. ,hat is the :3$ =OA$ of the machine/ 2$hat is, what is the initial cash outflow/5 $ &2+1,000 4. ,hat are the net operating cash flows for Year 1 and 2/ Year 1 $ *+,' 0 =. Year 2 $ 0','00

,hat is the total value of the additional considerations at the end of the five .ears/ $ 11,000

!.

,hat is the :et ;resent Falue of the machine/ $ &0*'

39

10.

:atural 4everages is contemplating the replacement of one of its "ottling machines with a newer and more efficient one. $he old machine has a "oo> value of $ 00,000 and a remaining useful life of five .ears. $he salvage value of the old machine 2for depreciation and cash flow purposes5 is $50,000. $he firm can sell it now to another firm in the industr. for $200,000. $he new machine has a purchase price of $1.2 million, an estimated useful life of five .ears, and an estimated salvage value in five .ears of $20,000. 8dditional costs of installation will "e $25,000. It is e#pected to economiDe on operating costs and to reduce the num"er of defective "ottles. In total, an annual saving of $250,000 will "e realiDed if the new machine is installed. $he new machine will re7uire an additional $15,000 in inventor. 2spare parts5. $he compan. is in the 0 percent marginal ta# "rac>et and has a 12 percent re7uired rate of return. $he machine 7ualifies as a +&.ear propert. under E8=%A 2++(, 5(, 15(, *(5. 8. ,hat is the initial investment re7uired for this replacement decision/ &$)'0,000 4. ,hat are the net operating cash flows for .ears one and two/ $20+,*00 =. $+ 2,500

,hat is the value of the additional considerations in .ear 5/ &$2+,000

!.

,hat is the :3$ ;%3A3:$ Falue of this replacement decision/ &$1+0,))0

40

1).

Buang Industries is considering a proposed pro@ect for its capital "udget. $he compan. estimates that the pro@ect-s :;F is $12 million. $his estimate assumes that the econom. and mar>et conditions will "e average over the ne#t few .ears. $he compan.-s =<O, however, forecasts that there is onl. a 50 percent chance that the econom. will "e average. %ecogniDing this uncertaint., she has performed the following scenario anal.sis: 3conomic Acenario %ecession 4elow 8verage 8verage 8"ove 8verage 4oom ;ro"a"ilit. of Outcome 0.05 0.20 0.50 0.20 0.05 :;F 2$*0 million5 2$25 million5 $12 million $20 million $+0 million

,hat is the pro@ect-s e#pected :;F, its standard deviation, and its coefficient of variation/ 32:;F5 H $+.0 million :;F H $2+.' million =F H *.0*

41

CHAPTER TWELVE PROBLEMS 1. Uuic> 1aunch %oc>et =ompan., a satellite launching firm, e#pects its sales to increase ". 50 percent in the coming .ear as a result of :8A8-s recent pro"lems with the space shuttle. $he firm-s current 3;A is $+.25. Its degree of operating leverage is 1.', while its degree of financial leverage is 2.1. ,hat is the firm-s pro@ected 3;A for the coming .ear using the !$1 approach/ $ 0.*1 8 firm e#pects to have a 15 percent increase in sales over the coming .ear. If it has operating leverage e7ual to 1.25 and financial leverage e7ual to +.5, then what will "e the percentage change in 3;A/ '' percent +. $he =ongress =ompan. has identified two method of producing pla.ing cards. One method involves a machine having a fi#ed cost of $10,000 and varia"le costs of $1.00 per dec> of cards. $he other method would use a less e#pensive machine 2fi#ed costs H $5,0005, "ut it would re7uire greater varia"le costs 2$1.50 per dec> of cards5. If the selling price per dec> of cards will "e the same under each method, at what level of output will the two methods produce the same net operating income/ 10,000 dec>s . 8ssume that a firm currentl. has 34I$ of $2,000,000, !$1 of *.5, and !<1 of 1.0*5. If sales decline ". 20 percent ne#t .ear, then what will "e the firm-s e#pected 34I$ in one .ear/ $ 00,000 5. 8ssume that a firm has a !<1 of 1.25. If sales increase ". 20 percent, the firm will e#perience a '0 percent increase in 3;A, and it will have an 34I$ of $100,000. ,hat will "e the 34I$ for this firm if sales do not increase/ 8nswer: $'*,5'0 '. =alculate the current price per share 2;05 for Olson =orporation, given the following information. $he data all pertain to the .ear @ust ended. Aales H 10,000 units Aales price per unit H $10.00 Faria"le cost per unit H $ 5.00 <i#ed cost H $10,000 !e"t outstanding H $15,000 Interest rate on de"t H 5 percent $a# %ate H +0 percent =ommon stoc> shares outstanding H 10,000 shares 4eta H 1.5 >%< H 5 percent >E H ) percent ;a.out ratio H 0 percent Growth rate in earnings and dividends H * percent $ 2). +

2.

42

*.

8 compan. currentl. has assets of $5 million. $he firm is 100 percent e7uit. financed. $he compan. currentl. has net income of $1 million, and it pa.s out 0 percent of its net income as dividends. 4oth net income and dividends are e#pected to grow at a constant rate of 5 percent per .ear. $here are 200,000 shares of stoc> outstanding, and it is estimated that the current cost of capital is 1+. 0 percent. $he compan. is considering a recapitaliDation where it will issue $1 million in de"t and use the proceeds to repurchase stoc>. Investment "an>ers have estimated that if the compan. goes through with the plan, its "efore ta# cost of de"t will "e 11 percent, and the cost of e7uit. will rise to 1 .5 percent. $he compan. has a & percent federal&plus&state ta# rate. 8. ,hat is the current share price 2"efore recapitaliDation5/ $25.00 4. 8ssuming that the firm maintains the same pa.out ratio, what will "e its stoc> price following the recapitaliDation/ $25.01

0.

$he 8=3 ,ine =ompan. of 3l ;aso produces a popular, low&cost wine. $he firm has fi#ed costs of $100,000 annuall. and varia"le costs per "ottle of $+.00. $he division has $150,000 in de"t outstanding at an annual interest rate of 12 percent. 8. If the price per "ottle is $*.00, what is the division-s "rea>even revenue/. $ 1*5,000 4. If the firm e#pects to sell 100,000 "ottles, at what price must it sell each "ottle in order to "rea> even/ $ .00 =. If the firm sells 50,000 "ottles at a price of $*.00, what is the firm-s degree of operating leverage/ 2.00 !. If the firm sells 50,000 "ottles at a price of $*.00, what is the firm-s degree of financial leverage/ 1.22 3. ,hat is the degree of total leverage at this level of output and sales price/ 2.

).

$he firms B1 and 11 are identical e#cept for their leverage ratios and interest rates on

43

de"t. 3ach has $20 million in assets, earned $ million "efore interest and ta#es in 2000, and has a 0 percent federal&plus&state ta# rate. <irm B1, however, has a leverage ratio 2!C85 of 50 percent and pa.s 12 percent interest on its de"t, whereas 11 has a +0 percent leverage ratio and pa.s onl. 10 percent interest on its de"t. 8. ,hat is the return on e7uit. for each firm/ %O3 for 11: %O3 for B1: 4. 1 .' percent 1'.0 percent

If 11 raises its de"t ratio to '0 percent and the interest rate on all of its de"t increases to 15 percent, what would its new %O3 "e/ %O3 for 11 at '0 percent !C8: 1'.5 percent

10.

$he ?YR =ompan. manufactures and sells onl. one product, a widget. $he firm sells ever. unit that it produces for a sales price of $5.00 a unit. $he firm-s varia"le cost per unit is $2.00, and the fi#ed operating cost is $+0,000. ?YR has current interest costs of $15,000 annuall. and a marginal ta# rate of 0 percent. If the firm produces and sells 20,000 units: 8. ,hat is the firm-s "rea>even 7uantit. and revenue/ 10,000 units and $50,000 4. ,hat is the firm-s degree of operating leverage/ 2.0 =. ,hat is the firm-s degree of financial leverage/ 2.0 !. ,hat is the firm-s degree of total leverage/ .00

11.

8 group of retired college professors has decided to form a small manufacturing

44

corporation. $he compan. will produce a full line of traditional office funiture. $wo financing plans have "een proposed ". investors. ;lan 8 is an all&e7uit. alternative. Knder this agreement, one million shares will "e sold to net the firm $20 per share. ;lan 4 involves the use of financial leverage. 8 de"t issue with a 20&.ear maturit. will "e privatel. placed. $he de"t issue will carr. an interest rate of 10 percent, and the principal "orrowed will amount to $' million. 8ssume a corporate ta# rate of + percent. 8. <ind the 34I$ indifference level associate with the two financing alternatives. $2,000,000 4. ,hat is the 3;A at this indifference level of 34I$/ $1.+2 =. $he average annual 34I$ has "een estimated at $+,000,0006 what is the e#pected 3;A of each plan at this level of 34I$/ ,hich plan should "e selected/ ;lan 8: $1.)0 ;lan 4: $+. +

45

12.

<our recent li"eral arts graduates have interested a group of venture capitalists in "ac>ing a new enterprise. $he proposed operation would consist of a series of retail outlets to distri"ute and service a full line of vacuum cleaners and accessories. $hese stores would "e located in Bouston, !allas and Aan 8ntonio. $wo financing plans have "een proposed ". the graduates. ;lan 8 is an all&common e7uit. structure. $wo million dollars would "e raised ". selling 00,000 shares of common stoc>. ;lan 4 would involve the use of long&term de"t financing. One million dollars would "e raised mar>eting "onds with an effective interest rate of 12 percent. Knder this alternative, another million dollars would "e raised ". selling 0,000 shares of common stoc>. ,ith "oth plans, then $2 million is needed to launch the new firm9s operations. $he de"t funds raised under ;lan 4 are thought to "e part of the firm9s permanent capital structure. 8ssume a + percent marginal ta# rate for the anal.sis. 8. <ind the 34I$ indifference level "etween the two proposals. $2 0,000 4. ,hat is the 3;A at this indifference level of 34I$/ $1.)0 =. $he average annual 34I$ has "een estimated at $500,0006 what is the e#pected 3;A of each plan at this level of 34I$/ ,hich plan should "e selected/ ;lan 8: $ .125 ;lan 4: $'.2*

1+.

$he ,ingler =orporation supplies headphones to airlines for use with movie and stereo programs. $he headphones use the latest in electronic components and sell for $20.00 per set. $his .ear-s sales are e#pected to "e 50,000 units. Faria"le production costs for the e#pected sales under present production methods are estimated at $10,200,000, and fi#ed production costs at present are $1,5'0,000. ,ingler has $ ,000,000 of de"t outstanding at an interest rate of 0 percent. $here are 2 0,000 shares of common stoc> outstanding, and there is no preferred stoc>. $he dividend pa.out ratio is *0 percent, ,ingler is in the 0 percent federal&plus&state ta# "rac>et. $he compan. is considering investing $*,200,000 in new e7uipment. Aales would not increase, "ut varia"le costs per unit would decline ". 20 percent. 8lso, fi#ed operating costs would increase from $1,5'0,000 to $1,000,000. ,ingler could raise the re7uired capital ". "orrowing $*,200,000 at 10 percent or ". selling 2 0,000 additional shares at $+0 per share. 8. Old: 4. ,hat would "e ,ingler-s 3;A under 215 the old production process6 225 under the new process if it uses de"t, and 2+5 the new process if it uses e7uit./ $2.0 :ew de"t: $ .* :ew e7uit.: $+.2*

8t what unit sales level would ,ingler have the same 3;A if the new production process is implemented/ ,hat is the 3;A at this level/ ++),*50 units and $1.00

46

CHAPTER THIRTEEN PROBLEMS 1. =raven =orp. has retained earnings of $1.*5 million and 100,000 shares of stoc> outstanding with a mar>et value of $25 per share. If =raven declares a 15 percent stoc> dividend, what will =raven-s retained earnings "e after the dividend/ $ 1.+*5 million 2 8 compan. has a net income of $100 million and a polic. of pa.ing out '0 percent of its earnings in dividends. Bow much total financing can "e accomplished "efore the compan. has to sell common stoc>/ 8ssume a de"tCe7uit. ratio of ''.' percent. $ ''.'' million +. 8lton =orp. has earnings of $1.5 million and a polic. of pa.ing out '0 percent of earnings. 8lton has $1.0 million in accepta"le investments "ut is una"le to issue new e7uit.. 8ssuming a !C3 of 0. , how much will 8lton "e a"le to spend on capital "udgeting if it wishes to stic> with the '0 percent pa.out/ $ 0.0 million . 4efore a 2&for&1 stoc> split, !ean =ompan. sold for $'0 a share, earning $15 and pa.ing $0 dividend per share. 8fter the split, the dividend per share "ecomes $5.20. 4. what percentage has the pa.out ratio risen/ +0( 5. 4utler =orporation has declared a 10 percent stoc> dividend. 4utler has 2 million shares outstanding with a current mar>et price of $*. Its capital stoc> account is $1 million, and the firm-s retained earnings are $0 million. ,hat "alances will the retained earnings and capital stoc> accounts show after the distri"ution of the stoc> dividend/ =8;I$81 A$O=M $ 1,100,000 '. %3$8I:3! 38%:I:GA $ ','00,000

$he Aherman Ateel =ompan. has an order "ac>log of $5 million. It desires to e#pand production capacit. ". 20 percent, which will involve a $15 million investment in plant and e7uipment. Eanagement desires to maintain 0 percent de"t in its capital structure. $he dividend polic. has "een to distri"ute 25 percent of their after&ta# earnings, which this .ear were $' million. If management wishes to maintain its dividend polic., how much e#ternal e7uit. must the firm see> at the "eginning of the .ear/ $ ,500,000

*.

On Earch 15, the directors of Glut Oil =ompan. met and declared the regular dividend of 0 cents a share to holders of record on Earch +1, pa.ment to made on Ea. 15. Of the 100 shares of Glut Oil .ou now own, 25 shares at a time were purchased on each of the following dates: Ianuar. 1, <e"ruar. 15, Earch 15, and 8pril 1. ,hat total dividends will .ou receive/ 28ssume e#&dividend four da.s prior to record date.5 $ +'.00

47

0.

,il"ert =ompan. e#pects ne#t .ear-s after&ta# income to "e $10 million. $he firm-s current de"t&e7uit. ratio is 100 percent. If ,il"ert has $12 million of profita"le investment opportunities and wishes to maintain its current de"t ratio with no e#ternal e7uit. financing, how much should it pa. out in dividends ne#t .ear/ $ ,000,000

).

Iaco"s =orporation earned $2 million after&ta#. $he firm has 1.' million shares outstanding. If Iaco"s- dividend polic. calls for a 0 percent pa.out ratio, what are the dividends per share/ $ 0.50

10.

=hampou# Bair <actor., Inc. has earnings "efore interest and ta#es of $100,000. 8nnual interest amounts to $ 0,000, and the annual depreciation is $ 0,000. $a#es are computed at the 0 percent rate. 3#isting "ond o"ligations re7uire the pa.ment of $20,000 into a sin>ing fund. =hampou# wishes to pa. $1 per share dividend on the e#isting 20,000 shares outstanding. $he firm-s "ond indenture prohi"its the pa.ment of dividends unless the cash flow 2"efore ta# and sin>ing fund pa.ments5 is greater than the total dividend, interest, and sin>ing fund o"ligations. ,hat is the ma#imum dividend per share that =hampeou# can pa./ $ 0.00

48

11.

One share of Fan Born !istri"utors, Inc. has a mar>et price of $120. $he firm lists the following on its annual report 2dollars in thousands5: =ommon Atoc>, $2.50 par6 authoriDed, ',000,000 shares6 issued and outstanding, ,000,000 shares 8dditional ;aid&In =apital %etained 3arnings 8.

$ 10,000 +,000 50,000

$he firm is considering a 5&for&1 stoc> split. ,hich of the following would "e e#pected/ 8ppro#imate ;ar Falue Ahares Issued Ear>et ;rice $ 0.50 20,000,000 $ 2 .00

4.

,hat would the "alances in the e7uit. accounts "e if the firm issued a one percent stoc> dividend/ =ommon Atoc> $ 10,100 8dditional ;aid&In $ *,*00 %etained 3arnings $ 5,200

12.

8"erwald Beating, Inc. has a si#&month "ac>log of orders for its patented solar heating s.stem. Eanagement plans to e#pand production capacit. ". 50 percent, with an $12 million investment in plant machiner., to meet this demand. $he firm wants to maintain a +0 percent de"t&to&asset ratio in its capital structure6 it also wants to maintain its past dividend polic. of distri"uting +0 percent of last .ear-s after&ta# earnings. In 1))0, after&ta# earnings were $2 million. 8. If the firm has 1,000,000 shares outstanding, what will "e the firm-s dividends per share 2!;A5 if it continues the current polic./ $ 0.'0 4. ,hat would the dividend per share "e if the firm emplo.s the residual theor. of dividends/ 8ssume 1 million shares outstanding. $ 0.00 =. If 8"erwald is to meet "oth capital funding and dividend re7uirements, how much e#ternal funding will "e re7uired/ $ *,000,000

49

1+.

Iaco"s =orporation earned $2 million in after&ta# net income last 7uarter. $he firm has 1.' million shares outstanding. If Iaco"s- dividend polic. calls for a 0 percent pa.out ratio, what are the dividends per share/ $0.50 per share

1 .

Ea#i&$rac>-s profit margin and sales are e#pected to "e 10 percent and $50 million, respectivel., for the upcoming 7uarter. $he firm-s traditional pa.out ratio is 0 percent of net income. !ue to mar>et conditions, the firm does not wish to raise an. new e7uit. at this time. Ea#i&$rac>-s optimal capital structure contains 0 percent de"tC'0 percent e7uit.. 8. ,hat is the firm-s e#pected net income/ $5,000,000 4. ,hat is the firm-s e#pected level of retained earnings/ $+,000,000 =. ,hat is the largest capital "udget that Ea#i&$rac> select without changing the firm-s pa.out polic. or capital structure weights/ $5,000,000